China’s reform challenges

When Deng Xiaoping initiated China’s market-oriented reforms 35 years ago, he – and the Chinese Communist Party – was taking the biggest political risk since the founding of the People’s Republic in 1949. When President Xi Jinping unveiled his own reform agenda at last year’s Third Plenum of the 18th CCP Congress, he was taking an equally large risk. Will his strategy pay off?

In 1979, Deng was in a difficult situation. He knew that the shift from centrally planned egalitarian socialism toward market-oriented capitalism could destabilize the CCP’s rule, and the unequal accumulation of wealth in the short term could cause significant social and political division. But, with China on the verge of economic and social collapse, following the decade-long chaos of the Cultural Revolution, he had to take action – and there were few, if any, alternatives available.

The reforms turned out to be extremely rewarding: more than three decades of double-digit economic growth followed their implementation. Moreover, they allowed the CCP to retain its hold on power. But they benefited some people and regions much more quickly than others – a problem that was tougher to address than Deng had anticipated.

Xi’s reforms, like Deng’s, reflect the absence of alternatives. Not only has China’s labor-intensive, investment-led growth model run out of steam; bureaucratic inefficiencies and pervasive corruption – not to mention severe and worsening pollution – are also damaging China’s long-term prospects. Only by addressing these weaknesses and shifting to an innovation-based, environmentally sustainable growth model can the country continue to prosper – and ultimately achieve high-income status.

The difference between the two reform efforts is that Xi must also address the shortcomings of Deng’s work. Deng mistakenly believed that the state, which retained its central role in the economy, would be able to use new market-generated resources to correct the short-run inequalities created by his reforms. But the bureaucracy and its privileged networks benefited most, and a second, non-market source of inequality – endemic official corruption – became entrenched. That is why Xi’s anti-corruption campaign was a critical precursor to reform.

In other words, beyond completing China’s transformation into an open, market-based economy, Xi must establish a strong rule of law that applies to all, while addressing acute inequality of income, opportunity, wealth, and wellbeing. For this reason, Xi must pursue reforms that allow people, money, resources, information, and companies to move more freely across sectors, regions, and national borders.

The resulting convergence of wealth and opportunities would generate massive economic and social gains. But, by effectively transforming the economic geography of China, Asia, and the world, liberalization would also lead to significant creative destruction. Furthermore, market forces could reduce inequality in the longer term only if China’s authorities tolerated the short-term inequalities created by fluctuations in prices for housing, stocks, labor, natural resources, and currency.

The problem is that the Chinese bureaucracy prefers stability, and it has strong incentives to strengthen its own position relative to the market, thereby exacerbating power inequalities and dampening innovation and growth. Yet the bureaucracy remains integral to the implementation of any policy that promotes social cohesion.

To mitigate the serious systemic risks stemming from the power of China’s overweening, corrupt mandarins, Xi must rebalance their incentives. He is already working to eliminate graft, restrict the scope of administrative approvals, reduce the state-owned sector’s advantages, clarify property rights in land, and simplify welfare, tax, and financial regulations. Beyond reducing systemic risks, these efforts – if they are sustained – could generate “reform dividends” over time.

But the incentive problem is not confined to the bureaucracy. Systemic reform requires recognizing and atoning for two original sins: not only that of bureaucrats who made money by abusing their power, but also that of capitalists who made money by breaking the rules.

This challenge is best illustrated in the competition between state-owned enterprises and private firms. The failure of private firms that lack access to subsidies or affordable financing deters others from innovating and challenging the status quo. Meanwhile, SOEs – which can invest in excess capacity, record net losses (often through corruption and incompetence), and count on government subsidies – never face a reckoning.

The implication is that macroeconomic policies like low interest rates and easy access to credit should be used to ensure equal access to credit for all qualified companies, based on their competitiveness, not their ownership. Unfortunately, implementing such measures would entail micro-level bureaucratic intervention, leading to further expansion of state powers. That is why the bureaucracy must be given incentives – higher salaries, clear performance indicators, and awareness that abuses of power will not be tolerated – to abandon the micro-management of market activities.

China’s recent relaxation of macroeconomic policy, despite ongoing market volatility, is an important step toward breaking unnecessary barriers to implementing the reforms needed to mitigate systemic risks. Now that Xi’s anti-corruption campaign has taken down some of the CCP’s biggest “tigers,” it is time to focus on structural reform.

With the right approach and sustained political will, Xi’s risk-taking can bring China the kind of returns that Deng’s did – and more.

This article is published in collaboration with Project Syndicate. Publication does not imply endorsement of views by the World Economic Forum.

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Author: Andrew Sheng is a distinguished Fellow of the Fung Global Institute and a member of the UNEP Advisory Council on Sustainable Finance, is a former chairman of the Hong Kong Securities and Futures Commission. Xiao Geng is Director of Research at the Fung Global Institute.

Image: Pedestrians walk under red lanterns in Shanghai, January 24, 2014. REUTERS.